Where Ellerston finds stocks with upside that is triple the risk

The resilience of consumers as the RBA ratcheted up rates is now frequently cited by asset managers asked to reflect on recent history. This resilience now hangs in the balance, says Ellerston Capital Portfolio Manager Alexandra Clarke. She’s not concerned, however – such dislocations present investment opportunities as company earnings come under pressure.

As we head into a new financial year, we’ve been tapping professional investors for their views on various parts of the market. In the following, Clarke explores ASX small-caps and some of the biggest drivers of her fund’s returns in the first half – including a few standout stocks.

Clarke also discusses how her team’s investment process provides certainty regardless of where the market moves, and shares what has her most excited for the second half of 2024.

What has been the biggest driver of returns for your asset class over the past six months?

We have seen stability in the interest rate environment, which has allowed the market to start pricing risk. This has seen a rotation out of cyclicals and consumer discretionary names, into Industrials and Technology stocks.

We have also seen risk capital moving toward Biotech’s away from Small Resources, as the market is hoping to capitalise on late-stage Phase 2 or Phase 3 trial wins.

Looking more closely at Technology stocks, the market is rewarding those names that have gone from being big cash burners when they swing into generating cashflow. Two stocks we have in the portfolio which fit this camp are Life360 (ASX: 360) – which put on over 100% in the last six months – and a more progressed technology stock like Rpmglobal (ASX: RUL) – which added 60% over the same period.

We have also seen a good rebound in financial stocks like Zip Co (ASX: ZIP), which is up 120%. This has been driven by the market coming to better understand the strategy that the new management team was rolling out, as well as the capital structure being completely reset.

What have been the biggest surprises since January and how have they impacted the way you are investing?

The biggest surprise has been the general resilience of markets and asset prices over the last six months or so. If you think back to January, markets had just experienced a massive run through the November - December period as everyone was convinced that the rate cycle had peaked and the first round of rate cuts were imminent.

It is now July, inflation remains stubborn, and the first round of rate cuts may still be months away, especially in Australia. The resilience of the Australian consumer and the Australian economy more broadly underpinned earnings growth across most industries, more than offsetting the expected valuation impact of prolonged higher rates.

The resumption of earnings growth as the key driver of share prices plays well into the way we tend to invest, as our investment style is premised on fundamental analysis and stock picking rather than trading macro trends. We continue to look for a 3:1 risk/return which can generate circa 15% pa over a three-year period.

What is the biggest risk to your outlook - what would cause you to change your investment thesis?

The biggest risk, in our view, is the early signs of consumer exhaustion. Prices of non-discretionary spending including electricity, gas and housing continue to press higher at a time when savings rates have decreased dramatically, and savings buffers established during the COVID years have almost reached exhaustion. This could be early signs that an earnings downgrade cycle could emerge over the next six to 12 months. This wouldn’t necessarily change our thesis. As active managers, we are always looking for changes in industry trends to take advantage of sectors showing growth and resilience whilst avoiding those where earnings pressure have become, or we expect will become, evident in the near term.

As industry- and stock-specific fundamentals takeover as the key driver of share price performance, we expect active managers to regain the upper hand relative to passive index investing which has materially benefited from an era of low rates and excessive liquidity which temporarily swamped fundamentals as the key driver.

How different will your portfolio be in the second half of the year versus the first half?

Our bottom-up, fundamental approach to stock selection, which feeds into portfolio construction, does not change. The composition of the portfolio, however, does change based on the targets identified through that process.

At a high level, we would expect the portfolio to continue to skew towards industries that display characteristics of strong pricing power, flexibility in the cost base and revenue streams which are less macro-dependent.

What has you most excited for the rest of this year?

Over the last two to three years, there has been a clear disparity between the performance of Australian large-cap companies relative to the small-cap end of the market. The last six to nine months have shown the first signs of recovery across the small-cap end of the market and we expect this trend to accelerate over the coming 12 months. Further to this, we would expect the next stage of the rally to broaden out across more of the small-cap market and expand into the micro-cap market.

What would you say to investors considering investing in your asset class?

There has been a lot of debate in recent years about active versus passive management and the obvious differential in fees.

We would encourage people to think about the best way for them to maximise their after-fee returns when considering investment strategies and manager selection.

We would also encourage them to review their fund managers' performance through the cycle.

Turning more specifically to small caps, equities are a growth asset class and, generally speaking, the fast growing, exciting and innovative companies in Australia are almost exclusively located at the smaller end of the market. This is the space where you get the opportunity to invest in the next Cochlear; Xero; Realestate.com; Breville; Seek; and JB-Hi-Fi, years before they become household names.

The ability to identify those types of businesses early in their growth phase can lead to outsized returns for active small-cap managers.

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Ellerston Australian Emerging Leaders Fund

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